It is fair to say that the past few weeks have been pretty choppy for markets.
We have seen some reasonably significant falls in both the US and the UK in recent days as the markets digest forecasts of inflation being higher for longer, economic growth slowing (and some countries now forecasting a mild recession) and supply chains continuing to be disrupted.
Given this outlook, we have been asked by a few clients in recent weeks whether they should look to de-risk their portfolio to prepare for what’s to come.
As sensible as this might sound, we actually think it could prove very damaging for your portfolio over the long term for all kinds of reasons.
First of all, in order for us to realise that there has been a change in direction in markets, by definition some of that change must have already happened. Most people would brush off a portfolio fall of perhaps -3%, -5%, -7% and so by the time we realise that we might need to take action, much of the damage would have already been done.
Second, this kind of action also assumes that in addition to correctly predicting that markets will continue to fall (which is far from certain), we also have to assume that we will get the timing right to switch back into a higher-risk portfolio. Of course, in order to realise that markets have turned a corner and started to recover, again, by definition, some of that recovery has already happened and thus been missed by the investor.
Again, let’s assume we need the market to recover by perhaps +5% or +7% for us to think “yes, this is a real recovery and not just a blip”.
As such, even based on the above example, using fairly modest portfolio falls and gains, we would have lost perhaps 10% just in the process of figuring out in which direction markets are travelling.
As counter-intuitive as it might sound, the more sensible move after suffering a market fall would actually be to increase the risk profile of your portfolio. This means (all other things being equal) that you are selling out of a portfolio that has done better (it has lost less) and buying into a portfolio that would have fallen by more (i.e. the assets are cheaper in relative terms).
Let me try to illustrate these two approaches with an example. Please note that these are ultra-simplified examples and are not designed to reflect the actual performance of the portfolios:
Example 1 – De-risking A Portfolio
Let’s say we have £100 invested in the Balanced risk portfolio (3 out of 5) and this portfolio has a beta (sensitivity to the market) of 1. This means that if the market falls by 10%, then the portfolio does as well.
The market drops 10% and so we now have a portfolio worth £90.
If we leave things as they are and the market recovers to its previous point, we will once again have £100.
If however, we switch into a Cautious portfolio (1 out of 5) and this portfolio has a beta of 0.5, then even if the market recovers to its previous point, then our portfolio is only worth around £95, leaving us with a £5 loss.
Example 2 – Increasing The Risk Profile In The Portfolio
Let’s say we have £100 invested in the Balanced risk portfolio (3 out of 5) and this portfolio has a beta (sensitivity to the market) of 1. This means that if the market falls by 10%, then the portfolio does as well.
The market drops 10% and so we now have a portfolio worth £90.
If we leave things as they are and the market recovers to its previous point, we will once again have £100.
If however, we switch into an Adventurous portfolio (5 out of 5) and this portfolio has a beta of 1.5, then even if the market recovers to its previous point, then our portfolio will be worth around £105, leaving us with a £5 gain.
At this stage, you could always switch back to the Balanced portfolio.
Please note that these are very simple examples designed to illustrate a point and will not be reflective of real-world performance.
So, in answer to the question “should I de-risk my portfolio?”, the answer will usually be ‘no’. There will, of course, be exceptional circumstances where this might prove sensible, but in general terms, there are two courses of action to consider during a time like this:
1. Do nothing at all and await the almost inevitable market recovery, which often comes much sooner than anyone predicts.
2. Increase the risk profile of the portfolio to capture more of the recovery on the way up.
